Swiss fund-of-funds: leading the way

The modest demand for private equity and venture capital in Switzerland is overshadowed by the size of the fund-of-funds market there. To illustrate this, Swiss firms currently raising capital for fund-of-funds include Adveq Management, Capital Venture Partners (Capvent), LGT Capital Partners, ShaPE (Julius Baer and Robeco), Swiss Life Private Equity Partners and Unigestion. The size of this industry is a legacy of the well-developed banking and financial services industry in Switzerland and Sylvia Graemiger Theler, vice president of Partners Group, says alternative investments are an important part of the Swiss investment tradition.

The fund-of-funds concept began to take-off in Switzerland in 1996 to 1997. At this time Unigestion, which now has a third of its EURO3 billion assets in private equity, disposed of its banking interests in order to focus on asset management. In collaboration with private Swiss bank Pictet, it launched its current line of fund-of-funds in 1997 with Unicapital I and is currently raising Unicapital IV, still in partnership with Pictet. Like many firms that took up fund-of-funds it had been managing hedge funds for some time (since 1986). David Chamberlain, managing director of Unigestion, says the two types of funds still complement each other well and it means the firm has more than just private equity to offer investors interested in alternative assets. It was also around this time that Partners Group launched its first fund-of-funds product, the listed Castle Private Equity, with Liechtenstein Global Trust. LGT Capital Partners now operates independently from the LGT group, managing both private equity and hedge fund investments. It is currently raising Crown Premium Private Equity Technology Ventures with German advisor, Solutio.

The Swiss fund-of-funds industry has come a long way in the five years since 1997 and is now marked by the growing number of competitors, with some players saying the market is saturated. Of the 600 attendees at the European Venture Capital Association’s International Investors Conference in Geneva in March this year, a third were investors, and out of this group 72 represented fund-of-funds. Chamberlain sums up what is generally a good-natured attitude to local competitors: “The market is extremely crowded but it’s good quality competition and everyone offers a different solution. There’s a wealth of talent in asset management here.” However, as far as returns are concerned the firm avoids non-private equity benchmarks and focuses on returning a premium on other fund-of-funds.

Andre Jaeggi, managing director of Adveq Management, which also raised its first fund-of-funds in 1997 believes fund-of-funds have suffered from the hype surrounding them. He says: “Players need to bring something new to the market, the “me too” market for fund-of-funds is already over-crowded, I think there are now around 40 just in Germany.” He says the fund-of-funds set up by banks and corporate finance houses have increased the market pressure but believes investors will realise that some of these funds do not represent good value.

Graemiger Theler of Partners Group is predicting difficult times ahead: “There will be consolidation as the wheat is separated from the chaff but there’s still enough business to go around at the moment.” She also believes smaller fund-of-funds may come under pressure to reduce their management fees as they lack a track record and sometimes an experienced management team. Dominik Meyer was previously chief executive of Private Equity Holding, the fund-of-funds that last year split with bank Vontobel. He is now a partner at Swiss Life Private Equity Partners, which took over the fund’s management. He says the market is more mature than when he entered it in 1997. “I think the bigger houses will gain more of a market share. They benefit from larger set-ups, better access to resources and have the capacity to structure new products.”

Like the venture capital and buyout funds based in Switzerland, fund-of-funds there are staffed by an international mix of professionals with diverse backgrounds in direct private equity, industry, consulting and investment management. This multi-national mix facilitates pan European and global fund raising through the understanding of local investment cultures. However, Swiss fund-of-funds firms are still expanding internationally; Adveq recently set up a German subsidiary, Capvent is about to open a London office and Unigestion is looking at adding a Munich office to its existing network, which includes Paris and London.

Innovative structures

One of the characteristics of the Swiss market is the variety of innovative structures it has produced for fund-of-funds. All managers have their own justification for developing their individual fund structures, which are basically designed to meet the specific demands of their investors, which, as Switzerland is so central, means they must cater for all European markets. All of Unigestion’s funds are Luxembourg regulated mutual funds. Chamberlain said the firm opted for this structure rather than an offshore fund, which he feels makes the decision to invest in private equity for the first time complicated, as most potential investors were already familiar with its use in other asset classes. It is now used widely in Switzerland and has been adopted by Swedish investor, SEB, for its first fund-of-funds venture. Chamberlain believes limited partnerships are more friendly to general partners and do not offer limited partners enough protection, something he has to take into account when trying to attract savvy investors.

One of the attributes that helps managers establish themselves in this market is having at least one mandate to manage a large institution’s private equity commitments under their belt. Unigestion has been exclusive private equity advisor to Bloise Insurance for two years as well as managing hedge fund mandates for Nestle and Swissair pension funds. Chamberlain says: “These mandates need careful planning and a close dialogue with the investor, they’re more demanding than a fund-of-funds as the investors aren’t passive, they are more involved and more controlling.” Capvent, a relative newcomer having been founded in 2000, has secured the mandate to advise the private equity programme of RenditeWertBeteiligungen (RWB AG) a German retail fund-of-funds. It is looking for more opportunities to provide investment advisory services to institutional investors in the UK. It acts as a non-discretionary advisor, offering services including due diligence, screening and monitoring of investments.

After launching Castle, Partners Group continued using unconventional fund structures. In 1999 it launched Princess Private Equity Holding Limited, another listed fund, which was the first private equity investment vehicle with capital protection provided by Swiss Re. It was structured as a zero per cent coupon convertible bond with AAA rating from Standard & Poor’s. According to Graemiger Theler: “Castle and Princess address the hurdles faced by private clients and the listed models meet demands for liquidity, regulatory requirements, tax efficiency and transparency.”

German investment managers and pension fund managers have to invest in private equity products that comply with specific regulatory and legal requirements, Deckungsstock and Spezialfondsfaehigkeit. This means many funds must put a separate structure in place to attract this money, a potentially lucrative sector of the market. Unigestion uses this system, as does Capvent and Adveq, however listed funds already meet these stringent requirements. Partners Group also has a fund formatted as a tradable certificate, allowing private investors in Germany access to the product. Most recently Partners Group has raised Pearl Holding Limited, which offers capital protection but also a guaranteed income through the two per cent coupon. Graemiger Theler acknowledges that the market is increasingly competitive but says: “As long as people are still trying to copy our structures I’m not too worried about it.”

Is size the enemy of performance?

Other steps taken by fund-of-funds managers to differentiate themselves from the pack and give them a competitive advantage include increasing investment specialisation. According to Graemiger Theler specialisation may benefit both larger teams that have the experience and resources to devote to a specific sector, and small funds looking for a market niche to differentiate themselves. As long as they pick the right sectors.

Capvent Global Private Equity II, Capvent’s second fund-of-funds which is hoping to raise up to $400 million, has an investment strategy focused on a diverse range of sector and geographically focused funds ranging in size from $50 million to $300 million. Capvent feels this group of funds has been neglected by investors and intermediaries because private equity allocations have risen, meaning small funds fell below the radar of investors or else such small commitments were not viewed as efficient.

Capvent director Varun Sood is calling for a return to what he labels real economics. He’s not alone in believing that although there are still deal opportunities for super-sized buyout funds, they now face a number of problems. One of these is that the two per cent management fee on multi-billion funds mean managers have become complacent and are no longer “hungry” to earn their carry, leading to safe, low-returning investments that keep the fees rolling in. Jaeggi certainly believes there is pressure on some private equity funds, which have scaled up fund sizes without scaling up the internal structure, to reduce management fees. Also, uninvested capital is mounting up while exits for investments that have been made are not forthcoming. Investors are also beginning to question the ability of fund managers, some of which have strayed from their key competencies, to run funds that are many multiples the size of their previous fund. Graemiger Theler also thinks mega-funds will struggle to repeat their past performance, which enabled them to raise so much capital, and that there is now more value in small to mid-sized buyout funds.

However, most managers continue to offer a “pick n’ mix” selection of investment types, with some funds warning against over-diversification, which could lead to average returns. Although Adveq has raised five funds it essentially offers two programmes: high technology, early stages and Europe, all stages. Like other investors fund-of-funds are generally cutting back their venture capital commitments. Christophe De Dardel, responsible for venture commitments at Unigestion, says: “There’s not really enough choice, there’s only about ten really good VC funds in Europe while this sector is a lot more mature in the States.” However, US buyout funds are no longer seen to be offering good value, as the deals they invest in are viewed as too competitive and therefore likely to be over-priced.

Chamberlain says Unigestion stopped making direct investments to avoid any conflict of interests with investors and prevent the criteria for choosing funds from being altered, although he admits it’s good to have had the experience. Likewise, Adveq avoids direct investments. Jaeggi says: “Direct investments work as an amplifier of trends, they increase the negative effects during a downturn. They also need a different set of skills and, compared to a VC fund, a fund-of-funds can’t really add value to an investment.”

Switzerland’s prominence in the fund-of-funds industry means it is well positioned to develop secondary fund-of-funds as well. While there are not yet any devoted secondary funds most of the fund-of-funds dabble. Unigestion’s second fund (EURO150 million) focused on secondary positions and around 15 percent of the current fund is also destined for these investments. The density of private equity investors in Switzerland means there are plenty of deal opportunities, particularly small selective portfolios offered by disenchanted private investors. Secondary investments are particularly important for listed fund-of-funds, which are under pressure to put capital to work straight away. Graemiger Theler says Partners Group is well positioned to buy secondary investments and it allocates around ten per cent to 15 per cent of its funds both to small and syndicated larger deals, but she feels the market is still inefficient.

Investors going it alone

One of the potential problems facing fund-of-funds managers everywhere is that institutional investors, new to private equity, are using their products to gain an insight into the market before deciding to manage their own fund investments. Jaeggi is philosophical about this but not overly concerned: “We’ve seen this before and we’ll see it again. We’ve trained some of them! Some limited partners who invested in our first and second funds are already our competitors. But then some investors who decided to invest themselves have come back to fund-of-funds, having been badly burnt.” On this subject Graemiger Theler says investors often do not realise how much of a burden the administration of investments can be. Fund-of-funds do have specialist skills and as long as they have sound knowledge and can still add value they will be indispensable to big institutions. Sood takes the line that if this happens, managers are the ones to blame: “If we prove our worth they will continue to work with us.”

Graemiger Theler thinks private equity asset allocation still lags behind in Europe, although the UK is not so far behind the US. She expects the average allocation to rise from three per cent of an institution’s total portfolio to four per cent or five per cent in the next two to three years. Thomas Kull, of Bloise Asset Management, says investors’ decision-making processes may be taking longer but they are not generally scaling back on their private equity commitments. He feels the main threat to the asset class is that public markets are perceived to be offering bargains at the moment. Jaeggi says allocations are proceeding but as reserves have melted a two per cent private equity allocation is now five per cent and there has been a slight re-thinking with trustees feeling private equity is more risky.

Possibly in reaction to fears about reduced private equity investment, fund-of-funds are increasingly labelling themselves as service providers. Sood stresses this: “The idea of the fund-of-fund manager as a service provider is key, it’s not just about managing money.” He emphasises it is important to establish relationships, have a personal approach to investors and offer a more sophisticated tailored investment strategy that goes beyond asset management. “Investors need to know that it’s important to really understand the market and know how to value add, it’s not just about being lucky or riding the wave.” Capvent focuses on the fact that it uses experience gained from direct private equity investing, rather than generalist asset management approach.

Unigestion offers an investors’ club service that aims to transfer knowledge and information to investors. It facilitates meetings with private equity managers and gives investors access to due diligence reports. Chamberlain says it is used by all sorts of investors, from those who are new to the asset class to sophisticated investors. It is hoped that it increases understanding and confidence and may create serial private equity investors. “We’re selling services rather than a product and you need to focus on your customers’ needs. You have to be flexible and it helps to understand the investors’ other risks, not just private equity,” he says.

It seems that a service culture, rarely found in private equity funds, is emerging among Swiss fund-of-funds. Maybe this mindset and all it entails (increased transparency and encouraging better understanding of the asset class among investors) will, in time, spread to the funds they invest in. But against a backdrop which includes the State of Connecticut’s lawsuit against US buyout firm Forstmann Little and investment fund Millennium Partners suing VC fund meVC Draper Fisher Jurvetson, both investors and fund managers are becoming more picky about who they choose as partners. Investors are certainly more cautious but their expectations may be lower as well. And while the current market means investors are more demanding, forcing fund-of-funds to cater to the demands of trustees, the funds themselves are also looking for more sophisticated investors who understand what they are getting in to.

There’s a consensus that fund-of-funds managers appreciate investors who understand private equity. They are looking for investors who realise the importance of a stable, long-term team and that good returns demand continuous investment in the asset class, but whether they will be in a position to pick and choose remains to be seen.

No place like home?

According to the most recent European Venture Capital and Private Equity Association figures, in 2000 fund-of-funds contributed nearly a quarter, 23.9 per cent or CHF 238 million (EURO163 million), of the total capital raised by private equity funds in Switzerland. This compares to 13.6 per cent in the UK, 7.2 per cent in Germany and 9.6 per cent in France. Despite these figures Swiss fund-of-funds have so far failed to stimulate domestic growth in either the buyout or venture capital market to any noticeable degree. Chamberlain blames a lack of entrepreneurial spirit for stunting the Swiss venture capital market. He says Swiss skills are in managing, avoiding and slicing risk. While the UK and the US are more entrepreneurial, the failure of a business is still heavily stigmatised in Switzerland. However, Unigestion has invested in Swiss VC firm Index Ventures, as has Partners Group, while Adveq has yet to invest in any Swiss funds.